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Volume 10, Edition 26 | July 26 - July 30, 2021

Why Own Emerging Markets?

Doug Walters, CFA
Investors saw some volatility in emerging markets equities this week, providing a good opportunity to revisit why it still makes sense to hold them in a well-diversified portfolio.

Contributed by Doug Walters, Max Berkovich

Investors in emerging markets received a shock this week from a regulatory crackdown in China. We often get asked at times like these, “Why own emerging markets?” Good question!

The short answer is that emerging markets equities are an important part of a well-diversified portfolio and can improve risk-adjusted returns. To get the benefits of diversification, a portfolio needs to hold assets that tend to rise over time, but not necessarily at the same time. For example, in 2017, emerging markets outperformed US large-cap equities by around 20%. Over the next two years, US stocks fully closed that gap. The concept is counterintuitive, but adding volatile emerging markets can actually reduce your portfolio volatility and improve risk-adjusted returns!

As an investor, if you are concerned about owning emerging markets, you need to as yourself why.

  • If you are concerned because countries and stocks in the region fall outside of your investment mandate (e.g., US only, strong governance, etc.), then that, of course, is a legitimate concern. You must stick to your mandate.
  • However, if your concern is that emerging markets are risky, then your concerns are misplaced. Used properly, emerging markets exposure can provide your portfolio with better risk-adjusted returns.

Our approach to emerging markets is to invest selectively within our evidence-based factor framework. An important proven, persistent factor for emerging markets is “Quality.” We believe a focus on quality allows investors to get the diversifying effects of emerging market economies while attempting to avoid the more risky investments of the region.

6.5%

Second Quarter US GDP

US GDP for the second quarter was released on Thursday and missed expectations. The economy grew at an annualized rate of 6.5% in the second quarter versus the 8.5% expected by economists.

Headlines This Week

No Surprises

The Federal Reserve’s Federal Open Markets Committee had its monthly meeting this week. No big announcements were expected, and none were delivered.

  • The Fed talked about an economy that continues to strengthen, with some sectors still having a ways to go for a full recovery.
  • The inflation language remained unchanged, with expectations that the recent increase is transitory.
  • Taper discussions continued with the committee taking a “deep dive” into the subject, but there is no agreement yet on a plan.

GDP Disappoints; Stocks Up

US GDP for the second quarter was released on Thursday and missed expectations.

  • The economy grew at an annualized rate of 6.5% in the second quarter versus the 8.5% expected by economists.
  • US stocks were up on the day despite the disappointment.
  • This is likely one of those cases where bad (or at least “less good”) is good. The miss on growth, all else equal, means the Fed will be less likely to act quickly to withdraw stimulus. Stock investors like this!

Infrastructure Moving Forward

In Washington, Senators have had a preliminary vote on the bipartisan infrastructure bill, which passed handily.

  • The vote paves the way for a formal debate and has created optimism that a bill is on the way.
  • Democrats are now trying to push forward their $3.5T human infrastructure bill, which Senator Sanders says he has the votes to pass despite some Democrats in the Senate saying otherwise.
  • With recess fast approaching, should the bill pass, it may not be until the fall.

Another Covid Challenge

The covid delta variant continues to challenge the reopening/recovery story.

  • Southern states like Florida, Arkansas, Louisiana, and Mississippi see levels approaching or surpassing the winter surge.
  • In most areas, vaccination rates are still not high enough to stop the spread, and as a result, jurisdictions are beginning to institute vaccination mandates and incentives.
  • The continued uncertainty has been a drag on investor sentiment.

The Week Ahead

Labor Market on a Roll

Next week’s headline number will be nonfarm payrolls as the market checks in on the current labor market.

  • Expectations are that another 920k jobs were added in July, pushing unemployment down to 5.7% from June’s 5.9%.
  • Attention on the labor market continues to grow as the Fed stated in its meeting this week that “we are clearly on a path to a very strong labor market.”
  • As the timing of any tapering from the Fed is now largely dependent on the labor market’s recovery, any surprises, good or bad, could move the expected taper date.
  • The US economy is still missing around 6.7 million jobs for a full recovery, but with an estimated 3 million early retirements, that number could be closer to 4 million.
  • At the current pace of jobs added, that could mean full employment by the end of the year.

Growing Dissent

The Bank of England (BoE) is set to meet next Thursday to discuss their monetary policy with some growing disagreements between bank officials setting up an interesting meeting.

  • Two BoE officials broke ranks by publicly stating that they think it is time for the bank to begin withdrawing stimulus as inflation concerns continue to grow.
  • At present, the rest of the committee does not quite share this view as tapering any stimulus could be an even bigger risk to the economy’s recovery over inflation fears.
  • The bank is likely to reiterate that it is still early to withdraw stimulus even as the UK sees its vaccination rate increase.

Earnings

Another big week in the middle of earnings season will see some big names reporting.

  • A name that is certain to garner some attention next week will be AMC Entertainment (AMC).
  • The Reddit meme stock started the year at $1.35 on the brink of bankruptcy but has been saved by a wave of retail investors that pushed the stock to record highs of $72.
  • This soar in price has allowed the firm to raise enough capital to stay afloat but still faces strong headwinds as consumers are slow to return to theaters with limited big box-office films hitting the screens this year.
  • Other names to look out for next week include Uber (UBER), Beyond Meat (BYND), Lyft (LYFT), Virgin Galactic (SPCE), and General Motors (GM).

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